The income statement reports all the revenues, costs of goods sold and expenses for a firm. One expense reported here relates to depreciation. This expense is most common in firms with copious amounts of fixed assets. In the absence of these assets, depreciation doesn't exist as an expense on a firm’s income statement.
Depreciation represents the use of an asset in a company’s operations. When a company purchases a fixed asset, it expects the item to be in use for a number of years. Accurate reporting requires the item’s cost to be recorded as an asset. Each accounting period, accountants record depreciation expense on the income statement that represents the use of the asset.
Companies can calculate depreciation expense using a number of different methods. Two of the most popular include the straight-line and double declining-balance methods. Straight-line depreciation expenses the same amount off each year; double declining-balance depreciation allows for companies to advance depreciation expense and lower net income, resulting in larger tax savings.
Income Statement Effects
Depreciation is a noncash expense when compared to other items expensed each month. This artificially lowers a company’s net income and skews the cash movements listed on the income statement. To correctly account for monthly cash flows, accountants add back the depreciation expense to the net income. This provides a more accurate presentation for cash flow. The statement of cash flows is a separate statement that companies use to review cash movements.
Although depreciation only relates to fixed assets, other noncash items also affect the income statement: amortization and depletion. Amortization is the income statement expense that relates to intangible assets, such as copyrights and patents. Depletion expense is the use of natural resources, such as a coal mine. Both of these items are similar to depreciation in terms of overall effects on a company’s income statement.